Tax, investments and pension rules can change over time so the information below may not be current. This article was correct at the time of publishing, however, it may no longer reflect our views on this topic.

Pennon said group performance was in line with expectations ahead of full year results on 4 June.

South West Water's full year revenue is expected to decline, driven by unusually high levels of rainfall, which has been 50% above last year's levels. However, this year's revenue shortfall will be made up in future years, thanks to the regulatory mechanism, where revenues are set in advance.

Our view

With Viridor, the waste management business, on the way out, Pennon's focus is on one thing and one thing only - water.

If the deal's given the go ahead Pennon could receive cash proceeds of around £3.7bn. It plans to return some to shareholders, reduce debt, and keep some for future investment. All eminently sensible in our opinion.

As with most utilities, the potential for a reliable income is Pennon's main attraction. That's particularly true in light of the current pandemic. While many sectors are seeing significant hits to revenue, life as a water utility means earnings are more predictable. In return for providing an affordable water supply, Ofwat (the regulator) allows Pennon to earn an acceptable financial return. This return is reviewed every five years, which means earnings have tended to be more stable and predictable.

Stable earnings help underpin the dividend. The current policy, of increasing the payout by RPI inflation plus 4 percentage points each year, is very generous. But with a new regulatory period beginning this April and lasting until 2025, this policy is likely to change.

Ofwat's reduced what it considers to be 'acceptable' for the coming period and increased performance targets. Lower earnings tend to mean less generous returns for shareholders and that's been the case for Pennon's rivals. We suspect Pennon will follow suit.

To date Pennon's built a good record as a water business. Rigid cost control has helped generate some of the best regulated returns in the sector, while service levels have been good enough to earn rewards from Ofwat.

While the next regulatory cycle is set to be tougher, we see no reason why this shouldn't continue. Pennon's plans have received approval from the regulator and the group's confident it can continue to outperform. Investment using sale proceeds could help Pennon's quest for outperformance.

Against a backdrop of wider uncertainty, Pennon currently trades on 19.7 times future earnings, some way above the long run average. Given the reliable nature of Pennon's business, that doesn't come as too much of a surprise. The prospective yield is 4.3%, but be aware the dividend policy will likely change in June.

Trading statement

South West Water will end the current regulatory period in a net reward position on Outcome Delivery Incentives (ODIs). The group has accepted Ofwat's plan for the next regulatory period 2020 - 2025. Revenue in the period will be lower, as Ofwat has reduced the acceptable financial return it allows water companies to make. However, there is opportunity for the group to earn financial rewards by outperforming on ODI targets.

The sale of Viridor, which valued the waste management business at £4.2bn, is expected to complete this summer. Pennon notes Viridor continues to perform well, with growth being driven by ramping up existing plants. The Avonmouth facility is now commissioned and contributing to earnings.

In light of COVID-19, Pennon said enhanced cleaning and social distancing are being practiced at its plants. Where possible work is being done remotely.

Pennon said it has "strong funding and liquidity" in light of current uncertainty. The group raised £840m of new or renewed finance this year. Pennon has access to £1.6bn of cash and committed facilities.

With the sale of Viridor complete, Pennon will be focus on the water and wastewater businesses but said it would consider further growth opportunities that would add value. A further update, alongside a new dividend policy, will be announced at full year results on 4 June.

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

Our website offers information about investing and saving, but not personal advice. If you're not sure which
investments are right for you, please request advice, for example from our financial
advisers. If you decide to invest, read our important investment notes first and
remember that investments can go up and down in value, so you could get back less than you put in.